Successfully Seeking Surplus — 10 Top Tips to guide safely through the Moral Hazard Maze – for Employers Trustees and their advisers

Introduction

This article includes below 10 top tips in respect of pensions surplus and the regulatory regime.

The Government has recently announced its proposals to “introduce new flexibilities for well-funded defined benefit schemes to release surplus funds where it is safe to do so.” This has been positively received with a flurry of excitement within the pensions industry. Of course, the devil will be in the detail of the Government’s proposals and those will not be known until the Government publishes its response to the Defined Benefit (DB) Options consultation which they have indicated will be in Spring this year. 

However, it has left the industry with much to think about, including how any legislative reforms to enable easier returns of surplus would be structured, and building in safeguards to ensure protection of members’ benefits.

In particular, there is a need to consider how the new proposals for the return of pensions surplus will interact with The Pensions Regulator’s “Moral Hazard” regulatory regime. 

The Moral Hazard Maze

In essence, the move towards releasing surplus follows a period of over a decade of growth of The Pensions Regulator’s (TPR) powers in respect of conduct that may be materially detrimental to DB schemes or impact the return on a hypothetical insolvency (the so-called Moral Hazard regime). 

It is not clear whether the Government’s proposals will be restricted to circumstances where DB pension schemes are in surplus on a “buyout” basis and have locked in their investment approach (I will call this “Currently Secure Schemes”) so that there is no risk whatsoever that they will not be able to pay full member benefits. However, there must be a prospect (and indeed there have been some hints) that the proposals will go beyond this.

On the basis that the proposals to return surplus are to apply even to schemes that are not Currently Secure Schemes, then that raises some interesting Moral Hazard questions.  The scope and strength of TPR’s powers seems highly relevant to the question of payment of surplus:-

• A primary consideration for Trustees and TPR has been the safeguarding of member benefits. 
• Where there is conduct that may be materially detrimental to DB schemes or impacts the return on a hypothetical insolvency risk to member benefits, TPR has extensive powers to issue Contribution Notices (CNs) and Financial Support Directions (FSDs). These powers have been extended several times, due to the concern that that there may be persons who would otherwise take steps that put at risk member benefits. Indeed, there has been a wide range of regulatory investigations on this point, many of which Burges Salmon has worked on, including Silentnight and Bernard Matthews.
• A key question will be “When will the conduct of employers be fully aligned with the Government’s new regulatory principles for the return of surplus and when will it be seen as a step which is inappropriately putting member benefits at risk?”.
• The audit trail between the two issues may look strikingly similar, as both relate to the extraction of funds from the DB scheme. This wide grey line may create real issues for both the ability to establish cases against corporates that are not acting in line with the regulatory principles, but also uncertainty and risk for those other corporates who are seeking to comply with a new regime and its principles.
• A further key issue is that it is not only the employers that are within scope of TPR’s powers. There is a prospect that much will be asked of Trustees under the new regime and there must be a strong case for there to be statutory protections for trustees agreeing to a return of surplus.
• If the new regime is to be a success, such success will rest very substantially on the shoulders of the advisers. Corporates and Trustees will not wish to transfer such major asset amounts, without first obtaining considerable advice.
• But again, on its face, advice on surplus extraction looks the same or very similar to the very conduct that is now subject to penalties, including criminal penalties from TPR.
• This calls out for safeguards - definition and scope will again be an issue to strike the balance between industry and schemes. There is already an exclusion for insolvency advisers in connection with their advice, and a new exclusion from liability for advisers in relation to surplus could be a much-needed option. Again, the perimeter of that exclusion will be key to define.
• it appears that TPR’s statutory objectives will need to be amended. How far will the amendments in favour of industry go? It is likely that such an amendment will raise the prospect of greater tension and conflict between competing statutory objectives. How will these be resolved and how will all parties be able to assess how these differing objectives will impact day to day TPR investigations and regulation?

So how should this be dealt with?  This article focusses on the GPS to get you through the Moral Hazard Maze. Actually, it’s more like GPS, a map, breadcrumbs and some sixth sense – as generally there will be no one factor that helps protect all, but it will be a combination of layers of guidance and protection.

It is possible of course that the Moral Hazard legislation will be rewritten to create a total safe harbour so that a repayment of surplus (compliant with future regulation and guidance) would no longer be within the Moral Hazard regime. However, this article assumes that such an option would be very hard to effectively draft and apply and there will not be a safe harbour. 

The 10 Top Tips

My 10 Top Tips for dealing with Moral Hazard issues are:

Tip 1 Clear and Appropriate rationale – assessed as early as possible. From a factual basis, cases where TPR may determine that surplus payments are inappropriate may look very similar to ones that are instead fully aligned with policy. As such the purpose of the conduct in question will be one to develop from the outset, helping to address any queries on this.

Tip 2 Audit – A clear audit of the process by which a decision to pay surplus is taken, recording the nature of any negotiations and advice is key. Often when matters are reviewed by Courts, Ombudsmen or Regulators a core question will be whether a due and appropriate process has been followed.

Tip 3 Severability of audit. Regulators often ask or require that files are be provided to them, for example under TPR’s section 72 powers. Sometimes we see that files are difficult to provide in practice, for example there may be multiple topics on long email chains. This may seem like a minor admin issue but, in practice, clear and distinct audit files can help evidence that you took all due steps, and allow you to evidence this in an efficient and cost effective way.

Tip 4 Seeking Covenant Advice – It is likely a distinguishing factor between those cases that the TPR may or may not be concerned about will depend in part on the covenant of the scheme sponsor and/or its group. Expert advice on this is likely to be key.

Tip 5 Actuarial, Benefit, Data and History check – if a payment is to be made from a scheme it will be on the assumption that the scheme is in surplus. Of course, it is difficult to establish if this is actually the case if there is uncertainty over the actuarial assumptions, benefits, data or history of your scheme. A review of these will therefore very likely be sensible to underpin surplus decisions.

Tip 6 Privilege and keeping it – legal privilege is a fundamental principle respected by the Courts and generally TPR Section 72 requests do not extend to privileged legal advice. It is vital that clients have the opportunity to turn freely to their lawyers to seek views on the application of legislation and the respective merits and scope. Privilege is however a complex area, and legal privilege can sometimes be lost, for example where documents are shared too widely. Also, there may be times when you wish to waive privilege, to show what advice you have received on a particular topic. For similar reasons to severability of audit files, there can be real benefit in managing legal dialogue so that it can be shared effectively.

Tip 7 Clarify who owns privilege? A key question is which party has the privilege over a piece of advice. For example, an employer might choose to waive privilege over advice when the trustees thought they had the right to assert privilege over it, and visa versa. Likewise for a legal adviser advising a trustee or employer, the adviser itself will generally not own or be able to assert the privilege in their advice to the client. With the scope of TPR’s powers extending to advisers, advisers may wish to ensure that privilege extends to them and/or that they seek their own privileged advice.

Tip 8 Statutory Protections and Defences- There are a number of provisions and defences that are included within the pensions legislation. For example, in respect of one of the arms of the TPR Contribution Notice power there is a defence that (i) before the event (ii) the party considered the impact (iii) took all reasonable steps to mitigate (iv) reasonably concluded that detriment was addressed; and (v) did so with the advice and audit that would have been expected. Often employers and trustees do not use the defences that are available to them, even though doing so may materially reduce their risk.

Tip 9 Clearance- It is unclear to what extent Clearance from TPR will be available or necessary for surplus payments. In theory, the statute as it stands is wide enough to allow for Clearance already. Carefully considering Clearance, its merits and the extent to which it is available in practice will be an important topic to consider.

Tip 10 Dialogue Even if Clearance is not sought, it will be key to consider how to maximise protections through dialogue. Discussions with relevant stakeholders can often reduce risk in practice. Again, this is one for careful consideration on a case by case basis.

Conclusion - the need for clarity

The proposed reforms to surplus are exciting and could materially improve outcomes for members and employers.  It will be of critical importance for future legislation and TPR guidance to be crystal clear as to the interaction of the surplus regime with Moral Hazard and for employers, trustees and advisers to be clear on what is legally appropriate.

With so many key questions and issues to consider and factor into any return of surplus proposals. it is imperative that the Government, TPR and the industry start turning their minds to them now to ensure that all of these issues and various and differing interests are taken into account.